Capital & Operating Leases ODJFS Office of Fiscal & Monitoring Services Bureau of County Finance & Technical Assistance OJFSDA Conference, June 2009

Agenda Understanding the differences between operating and capital leases Understanding criteria to determine lease type Building leases

Agenda Recording lease activity Disposition of leased assets Summary

Operating Leases An operating lease is similar to rent:  it is for a stated portion of time (less than the useful life)  no ownership occurs from the relationship  rental costs are not directly associated with the acquisition cost of an asset

Capital Leases Capital leases are similar to a financed purchase:  an asset is essentially being purchased  the lease payment effectively consists of both principal and interest calculations

Capital Leases  the market value of the asset is capitalized and interest is imputed over the lease term  the capitalized value is depreciated over the asset’s useful life

Determination of Lease Type Capital Lease versus Operating Lease 1. Lease conveys ownership to the lessee at some point 2. The lessee has an option to purchase the asset at a bargain price 3. Term of the lease is 75% or more of the useful life of the asset 4. Present value of the minimum lease payments equals or exceeds 90% of the fair value

Determination of Lease Type Additional Criteria Lessee has a bargain renewal option that is sufficiently lower than fair rental value Beginning of the lease term falls within the last 25% of the useful life of the asset

Determination of Lease Type Additional Criteria - Bargain Renewal Option A bargain renewal rate is one that is sufficiently lower than the fair rental of the property at the date the option becomes exercisable

Determination of Lease Type Additional Criteria - Bargain Renewal Option If there is a bargain renewal option, the lease criteria for points # 3 and # 4 must be recalculated to include the extended lease term and the additional minimum lease payments

Determination of Lease Type Additional Criteria – Leasing used assets When the beginning of the lease falls within the last 25% of the useful life of the asset, comparisons of lease term to useful life as well as present value of minimum lease payments to fair value are irrelevant (points # 3 and # 4) Only points # 1 and # 2 should be reviewed in determining lease type

Determination of Lease Type Criteria # 1: The lease conveys ownership to the lessee during or at the end of the lease term  if ownership is transferred at any time, the lease is a capital lease and must be depreciated

Determination of Lease Type Criteria # 2: The lessee has an option to purchase the asset at a bargain price at the end of the lease term  if the lessee has the option of a bargain purchase, then the lease is a capital lease and must be depreciated  bargain purchase options exist when the purchase price is significantly below market value of the asset

Determination of Lease Type Criteria # 3: The term of the lease is 75% or more of the useful life of the asset  if the lease term is 75% or greater of the useful life as defined by the least restrictive useful life table (either county or DAS), the lease is a capital lease and must be depreciated

Determination of Lease Type Criteria # 4: The present value of the minimum lease payments equals or exceeds 90% of the fair value of the leased asset  if the present value of the minimum lease payments is 90% or more of the fair value of the lease, the lease is a capital lease and must be depreciated

Determination of Lease Type Additional Criteria - Bargain Renewal Option The lease contains a bargain renewal option that renews the lease at a sufficiently lower than fair rental value of the asset  the lives of both leases (original and renewal) are combined when evaluating point # 3  the minimum lease payments of both leases are combined when evaluating point # 4

Determination of Lease Type Additional Criteria - Leasing Used Assets The beginning of the lease term falls within the last 25% of the useful life of the asset (eliminates bullet points # 3 and # 4 as items of consideration)

Determination of Lease Type Additional Criteria - Leasing Used Assets  only points # 1 and # 2 need to be reviewed in determining lease type  if at the inception of the lease, 75% or more of the asset’s useful life has been consumed and points # 1 and # 2 are not applicable, the lease is an operating lease and the payments are expensed

Building Leases County family service agencies cannot own property and therefore, must enter into operating leases for office space Building leases may be between the agency and another entity or between the agency and the county (“Less-Than-Arm’s- Length” transaction)

Building Leases Lease or rental payments are allowable claims to federal programs and must be reasonable; criteria to consider for reasonableness should include:  rental costs of comparable property  market conditions in the area  alternatives available  the type, life expectancy, condition, and value of the property leased

Building Leases Operating leases need to be reviewed periodically to ensure the lease rates are reasonable  at a minimum, before lease renewals

Building Leases – “Less-Than- Arm’s-Length” Transaction  Where one party to a lease agreement is able to control or substantially influence the actions of the other party  Claimable costs are limited to those that would be allowable if title to the property was vested in the county agency

Building Leases – “Less-Than- Arm’s-Length” Transaction  Allowable costs are generally limited to depreciation, use allowance, maintenance, taxes, insurance, and related interest  Acquisition costs (less cost of land) are claimable as depreciation over the useful life of the asset on a straight line basis

Building Leases – “Less-Than- Arm’s-Length” Transaction  Demolition costs of an existing building on the site of a new building are not acquisition costs; they become part of the basis in the land

Building Leases – “Less-Than- Arm’s-Length” Transaction  Records supporting building lease rate should include: acquisition costs land and demolition costs (segregated from acquisition costs) renovation, capital improvements, and addition costs allocation of costs among multiple tenants

Building Leases – “Less-Than- Arm’s-Length” Transaction  The depreciable life of the building is based on the useful life utilized for financial reporting purposes the useful life should never be based on the bond life used for financing the purchase of the building

Building Leases – “Less-Than- Arm’s-Length” Transaction Documentation of Building Arrangements  an official agreement between the local agency and the county should exist defining the responsibilities of both the local agency and the county in relation to the building; this agreement should include terms of occupancy and the financial arrangements for the building’s use and related costs

Recording Lease Activity Operating Lease:  payment is an operating expense and should be charged to either the appropriate cost pool or benefiting program

Recording Lease Activity  QuIC+ Coding - Operating Lease: 010, 020, Account # (Cost Pool – Operations) -or- Program Project # - Account # (Project – Equipment Lease)

Recording Lease Activity Capital Lease:  payment is a combination of principal, interest and other operating costs  the market value of the asset at the beginning of the lease is depreciated over its useful life

Recording Lease Activity Capital Lease:  charges such as insurance, maintenance fees, etc. are operating costs and should be charged to either the appropriate cost pool or benefiting program

Recording Lease Activity Capital Lease:  interest is an operating cost and should be charged to either the appropriate cost pool or benefiting program  principal is charged to local dollars; the asset’s full market value is charged to local dollars over the life of the asset

Recording Lease Activity  QuIC+ Coding - Capital Lease Principal portion of payment: Project # Account # (Non-Reimbursable Expenditures – Equipment Lease) The effective cost of the equipment will be recorded over the life of the lease

Recording Lease Activity  QuIC+ Coding - Capital Lease Interest portion of payment: Project # - Account # (Cost Pool or Program – Operations) Ancillary charges portion of the payment : Project # - Account # (Cost Pool or Program – Operations)

Recording Lease Activity Capital Lease :  depreciation is an operating expense and charged to either the appropriate cost pool or benefiting program over the asset’s useful life based on a straight line basis  an off-setting entry for depreciation is also recorded as a negative expenditure to local dollars over the asset’s useful life

Recording Lease Activity  QuIC+ Coding - Depreciation Depreciation of capitalized value: Positive Entry: 010, 020, Account # (Cost Pool – Operations) -or- Program - Account # (Project # – Equipment Depreciation / Use Allowance)

Recording Lease Activity  QuIC+ Coding - Depreciation Depreciation of capitalized value: Negative Entry : Account # (Non-Reimbursable Expenditures – Equipment Depreciation / Use Allowance) Local expenditures are effectively reimbursed for the cost of the asset over its useful life

Disposition of Leased Assets Operating  assets are returned to the lessor and financial obligation normally ends Capital  assets may or may not be returned to the lessor, depending on the terms of the lease  disposition of assets need to be recorded on inventory and fixed asset records  gain or loss needs to be calculated and duly reflected in financial reporting

Disposition of Leased Assets Regardless of lease type, benefits received and incurred losses on the disposition of assets are normally applied to the benefiting program or cost pool

In Summary… Upon entering into a lease agreement, agencies need to determine if the lease is an operating or a capital lease After evaluating the four main criteria, there are two additional criteria which also needs to be considered as part of the determination

In Summary… Agencies need to properly classify and code lease transactions  Operating normal operational cost

In Summary… Agencies need to properly classify and code lease transactions  Capital market value of asset at the beginning of lease term imputed interest rate

In Summary… Agencies need to properly classify and code lease transactions  Capital ancillary charges portion of payment amortization of principal and interest portion of payment useful life of asset

In Summary… Building Leases:  Carefully define terms of the lease understand conditions of a “Less-Than- Arm’s-Length” transaction composition of building costs

In Summary… Building Leases:  Carefully define terms of the lease methodology for determining allowable and reasonable rental costs allowable use of building financial arrangements for building costs

In Summary… Additional Questions